SEMILLEROS ALMERÍA, SL Paraje La cumbre, s/n

The synergy hypothesis of M&As asserts that the value of combined firms after a merger is

larger than the sum of the returns generated by the two separated firms. Bradley et al. (1983)

found some support for this hypothesis, suggesting that M&As create synergies for the

combined entity by reallocating the resources of the firms. Unlike the information hypothesis,

which posits that managers have private information about the true value of the firm, authors

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suggest that managers generate gains by exploring potential synergies via M&As, which is

consistent with the synergy hypothesis. Bradly et al. (1988) investigated a sample of 236

successful tender offers in the period 1963 to 1984 and recorded an overall increase of 7.4

percent in the value of combined firms, providing additional support to the synergy hypothesis.

Jensen and Ruback (1983), by reviewing prior studies, found that M&As on average generate

gains, and targets benefit, whereas bidder firms at least do not lose.

A large body of M&A studies have summarised three main sources of synergies: operations,

finances and management improvement. Devos et al. (2009) attribute synergies to an

improvement of resources allocation. Using the value line forecasts to estimate synergy4, the authors found that the average synergy for a sample of 246 large mergers increased the value

of the combined entity to 10.03 percent. Of particular note, operating synergies take up 8.38

percent and financial synergies account for the remaining part. Hoberg and Phillips (2010)

suggest that large synergies are obtained through acquisitions of targets whose products are

different from bidder firms’ rivals, suggesting that synergies are created by a product differentiation strategy that intensifies bidders’ competitiveness and sets obstacles for their

rivals, making them hard to imitate. Using a large unique patent-merger dataset between 1984

and 2006, Bena and Li (2014) found synergies to be created through innovation activities

following M&As. Houston et al. (2001), who investigated a sample of the largest bank mergers

between 1985 and 1996, noted that bank mergers create value for bidders. In particular, the

authors identified the source of synergy in bank M&As as being mainly created from cost

savings rather than revenue enhancement.

4 _{In Devos et al. (2009), merger synergy was calculated as the forecasted incremental cash flows of the combined}

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Lang et al. (1989) explained synergy gains with the Q theory. Tobin’s Q is defined as the ratio

of a firm’s market value to the replacement costs of its assets. Q ratio measures the firm’s

performance, and the well-performing firms are those with a high Q ratio whereas the poor-

performing firms are those with a low Q ratio. Acquisitions involve a high Q bidder and a low

Q target generating large total gains for the bidder, the target and the combined firm. The results

imply that managers of a well-performing firm have abundant resources to improve the firm’s

performance whereas a poor-performing firm lacking investment opportunities is an ideal

target for synergy exploitation. Servaes (1991) reported supportive evidence by applying Lang

et al.’s idea (1989) to a larger sample with additional controls.

M&As play a disciplinary role with regard to managers who perform poorly. Jensen and

Ruback (1983) indicate that the market for corporate control creates value for the firm.

Managers compete for the rights to manage corporate resources, hence, poor management is

removed while good management serves the best interests of the shareholders via M&As. Jensen and Ruback’s view (1983) suggests that M&As enhance the firm’s efficiency by

removing an inefficiency management team. Palepu (1986) studied the inefficient management

effect on the likelihood of the firm to be acquired, and measured an inefficient management

team by means of average excess returns of the firm. His results show a negative relationship

between firms that are likely to be the M&A target and inefficient management, which is

significant at a 5% level. The conclusion of this inefficiency management hypothesis is that

managers who fail to ensure the commitment of value-maximisation for the firm are likely to

be replaced. Accordingly, Mitchell and Lehn (1990) found that firms whose managers perform

poorly following a merger is likely to be acquired by another firm. Martin and McConnell

(1991) affirmed high turnover rate for target managers following M&A completion and the

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similar vein, Lehn and Zhao (2006), by studying 714 acquisitions during 1990 to 1998, found

that 47% of top managers of bidder firms are dismissed within 5 years (including 16% due to

takeovers). Therefore, takeover threats for managers tend to create synergy for the firm.

However, Agrawal and Jaffe (2003), who included a sample of over 2,000 M&As from 1926

to 1996, reported little evidence that inefficient firms will necessarily be acquired. Measuring

the operating performance and stock market returns for the target firms, the authors revealed

that takeover targets are not all those underperforming firms prior to the M&A announcement.

In addition, targets do not underperform in the decade prior to M&A announcements regardless

of whether the performance was measured with the firm’s operating performance or stock

market performance. Results are robust when the authors take account of the size of the firm,

industry and past performance of the targets for the targets’ operating returns, and the size,

book-to-market value and past returns for the stock market performance. Results continue to

hold when employing an alternative benchmark model to calculate targets’ stock returns. The

authors proposed two main reasons why their findings fail to support Palepu’s inefficient

management hypothesis (1986). First, the primary M&A motive is not to remove the inefficient

management team in the sample, as there is only a small proportion of targets perform

inefficiently prior to M&A announcement date. Second, their sample did not include

disciplinary or attempted M&As that support the inefficient management hypothesis.

Jensen (1988) suggests that the market for corporate control brings forth economic benefits for

shareholders, society and the corporate form of organisation. Moreover, takeovers bring about

major changes fitting for the future development of firms. Such fundamental changes including

new recruitment and resources, offer new top-managers opportunities, forsaking the old

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corporate control effectively reallocates resources. Jensen (1988) indicates that major

restructuring activities create economic efficiency due to the influences of political and

economic conditions in the 1980s when many U.S. firms experienced revenue slowdown and

used M&As to cope with market changes. The author holds that the pressures of managers’

turnover and the political activity weaken M&A efficiency.